After roughly 10 weeks of falling FX volatility, an index that measures foreign exchange volatility has spiked up by nearly 25% over a span of 5 days. The catalyst for this pivot in volatility has been the reemergence of hard Brexit risks and US-China trade tensions, two themes that have been overhanging the markets for a while now.
Adding further volatility to this mix is the increasing chatter around the possibility that the US could intervene to weaken the USD. While many central banks have been singled out by the Administration for weakening its currency, the main focus of the President is clearly China. Because China exports more to the US than it imports from the US, China cannot match the US in terms of tariff scope. This leaves currency devaluation as a key way to help ease the impact of increased US tariffs. But it’s important to remember that there are limits to what currency devaluation can do as the following example illustrates.
Suppose the PBoC lets the yuan depreciate to match the percent increase in tariffs. From the US point of view, the cost of Chinese goods (in USD) remains unchanged, and the US government generates additional revenue. On the Chinese side, the devaluation in the yuan leaves China in the same competitive position as before. However, Chinese consumers have to pay more for imported goods, and Chinese businesses that have USD loan obligations owe more than before.
Of course, all of this does not preclude China from allowing the yuan to depreciate further. In fact, we continue to forecast depreciating pressure on the yuan. What it does illustrate is that currency depreciation to counter US tariffs isn’t an optimal or sustainable strategy.
Poor data continues to come out of the EZ with a recession in Germany looking increasingly likely. Recent EURUSD prices have seen the euro strengthen but that’s most likely positioning and USD weakness. The bias is still for EURUSD to go lower as domestic and global growth headwinds continue.
Q2 GDP data showed the first contraction since 2012. Risks of both a no-deal Brexit and a general election have risen with Labour looking increasingly likely to call a vote of no confidence once Parliament returns. Expect the pound to continue to drift lower as no-deal Brexit risks remain and the UK economy continues to face drags from global uncertainty.
USDJPY remains near its lows despite US 10-year yields rallying ~6% from recent lows as markets continue to sell into rallies. With the markets still in a defensive mode, expect safe haven currencies, like the JPY, to remain in demand. Calendar wise, Monday is a holiday in Japan and the JPY has a tendency to strengthen during Japanese holidays as liquidity dries up.
CAD has weakened this past week against broad dollar gains largely related to trade war-based market reactions and declines in prices of crude oil. While disappointing employment data foreshadows a slowing economy, markets are still anticipating rates to hold. The upcoming week is quiet concerning economic data coming out of Canada, and as global trade developments continue to unfold, it is anticipated that CAD will move with overall market sentiment.
After tariff action last week from the US, China responded with currency action this week. In response, the US labeled China a currency manipulator. This tit-for-tat escalation has not only ramped up the economic damage stemming from the US-China showdown but has also made de-escalation more difficult. Persistent headwinds from the trade conflict biases the CNY towards further depreciation but expect the PBoC to maintain stability in the near term.
Last week the AUD rallied from a 5-year low but still finished the week lower. The RBA is likely on hold at its August meeting, but Gov. Lowe has signaled a firmly dovish stance which implies further cuts. China allowing the CNY to break the CNY 7.00/$ level hints at China preparing for a long battle with the US. Domestic and global economic headwinds should cap any rallies and keep the AUD pressured.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 1.25%
Expectations for rates to remain unchanged at 8.25%
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